Returns to scale

In economics, returns to scale and economies of scale

are related but dierent terms that describe what happens as the scale of production increases in the long run,
when all input levels including physical capital usage are
variable (chosen by the rm). The term returns to scale
arises in the context of a rms production function. It
explains the behavior of the rate of increase in output
(production) relative to the associated increase in the inputs (the factors of production) in the long run. In the
long run all factors of production are variable and subject
to change due to a given increase in size (scale). While
economies of scale show the eect of an increased output level on unit costs, returns to scale focus only on the
relation between input and output quantities.

creasing returns to scale (IRS)

Assuming that the factor costs are constant (that is, that
the rm is a perfect competitor in all input markets),
a rm experiencing constant returns will have constant
long-run average costs, a rm experiencing decreasing
returns will have increasing long-run average costs, and a
rm experiencing increasing returns will have decreasing
long-run average costs.[1][2][3] However, this relationship
breaks down if the rm does not face perfectly competitive factor markets (i.e., in this context, the price one pays
for a good does depend on the amount purchased). For
example, if there are increasing returns to scale in some
range of output levels, but the rm is so big in one or
more input markets that increasing its purchases of an input drives up the inputs per-unit cost, then the rm could
have diseconomies of scale in that range of output levels.
Conversely, if the rm is able to get bulk discounts of
an input, then it could have economies of scale in some
range of output levels even if it has decreasing returns in
production in that output range.

The laws of returns to scale are a set of three interrelated

and sequential laws: Law of Increasing Returns to Scale,
Law of Constant Returns to Scale, and Law of Diminishing returns to Scale. If output increases by that same
proportional change as all inputs change then there are
constant returns to scale (CRS). If output increases by
less than that proportional change in inputs, there are decreasing returns to scale (DRS). If output increases by
more than that proportional change in inputs, there are
increasing returns to scale (IRS). A rms production 2 Formal denitions
function could exhibit dierent types of returns to scale
in dierent ranges of output. Typically, there could be
Formally, a production function F (K, L) is dened to
increasing returns at relatively low output levels, decreashave:
ing returns at relatively high output levels, and constant
returns at one output level between those ranges.
Constant returns to scale if (for any constant a
In mainstream microeconomics, the returns to scale faced
greater than 0) F (aK, aL) = aF (K, L)
by a rm are purely technologically imposed and are not
inuenced by economic decisions or by market condi Increasing returns to scale if (for any constant a
tions (i.e., conclusions about returns to scale are derived
greater than 1) F (aK, aL) > aF (K, L),
from the specic mathematical structure of the produc Decreasing returns to scale if (for any constant a
tion function in isolation).
greater than 1) F (aK, aL) < aF (K, L)

Example

where K and L are factors of productioncapital and labor, respectively.

When all inputs increase by a factor of 2, new values for In a more general set-up, for a multi-input-multi-output
output will be:
production processes, one may assume technology can be
represented via some technology set, call it T , which
Twice the previous output if there are constant re- must satisfy some regularity conditions of production
turns to scale (CRS)
theory.[4][5][6][7][8] In this case, the property of constant
returns to scale is equivalent to saying that technology set
Less than twice the previous output if there are de- T is a cone, i.e., satises the property aT = T, a > 0 .
creasing returns to scale (DRS)
In turn, if there is a production function that will describe
the technology set T it will have to be homogeneous of
More than twice the previous output if there are in- degree 1.
1

6 FURTHER READING

Formal example

The Cobb-Douglas functional form has constant returns

to scale when the sum of the exponents adds up to one.
The function is:

F (K, L) = AK b L1b
where A > 0 and 0 < b < 1 . Thus

[4] Shephard, R.W. (1953) Cost and production functions.

Princeton, NJ: Princeton University Press.
[5] Shephard, R.W. (1970) Theory of cost and production
functions. Princeton, NJ: Princeton University Press.
[6] Fre, R., and D. Primont (1995) Multi-Output Production and Duality: Theory and Applications. Kluwer Academic Publishers, Boston.
[7] Zelenyuk, V. (2013) A scale elasticity measure for directional distance function and its dual: Theory and DEA
estimation. European Journal of Operational Research
228:3, pp 592600

F (aK, aL) = A(aK)b (aL)1b = Aab a1b K b L1b = aAK b L1b = aF (K, L).
But if the Cobb-Douglas production function has its general form

F (K, L) = AK b Lc
with 0 < c < 1, then there are increasing returns if b + c
> 1 but decreasing returns if b + c < 1, since

[8] Zelenyuk V. (2014) Scale eciency and homotheticity: equivalence of primal and dual measures Journal of
Productivity Analysis 42:1, pp 15-24.

6 Further reading
Susanto Basu (2008). Returns to scale measurement, The New Palgrave Dictionary of Economics,
2nd Edition. Abstract.

F (aK, aL) = A(aK)b (aL)c = Aab ac K b Lc = ab+c AK b Lc =

ab+cM.
F (K,
L),
James
Buchanan
and Yong J. Yoon, ed. (1994)
The Return to Increasing Returns. U.Mich. Press.
which is greater than or less than aF (K, L) as b+c is
Chapter-preview links.
greater or less than one.

See also
Diseconomies of scale
Economies of agglomeration
Economies of scope
Experience curve eects
Ideal rm size
Homogeneous function
Mohring eect
Moores law

References

[1] Gelles, Gregory M.; Mitchell, Douglas W. (1996). Returns to scale and economies of scale: Further observations. Journal of Economic Education 27 (3): 259261.
JSTOR 1183297.

John Eatwell (1987). Returns to scale, The New

Palgrave: A Dictionary of Economics, v. 4, pp. 165
66.
Fre, R., S. Grosskopf and C.A.K. Lovell (1986),
Scale economies and duality Zeitschrift fr Nationalkonomie 46:2, pp. 175182.
Hanoch, G. (1975) The elasticity of scale and the
shape of average costs, American Economic Review 65, pp. 492497.
Panzar, J.C. and R.D. Willig (1977) Economies of
scale in multi-output production, Quarterly Journal
of Economics 91, 481-493.
Joaquim Silvestre (1987). Economies and diseconomies of scale, The New Palgrave: A Dictionary
of Economics, v. 2, pp. 8084.
Spirros Vassilakis (1987). Increasing returns to
scale, The New Palgrave: A Dictionary of Economics, v. 2, pp. 76164.

[2] Frisch, R. (1965). Theory of Production. Dordrecht: D.

Reidel.

Zelenyuk, V. (2013) A scale elasticity measure for

directional distance function and its dual: Theory
and DEA estimation. European Journal of Operational Research 228:3, pp 592600

[3] Ferguson, C. E. (1969). The Neoclassical Theory of Production and Distribution. London: Cambridge University
Press. ISBN 0-521-07453-3.

Zelenyuk V. (2014) Scale eciency and homotheticity: equivalence of primal and dual measures
Journal of Productivity Analysis 42:1, pp 15-24.

External links
Economies of Scale and Returns to Scale
Video Lecture on Returns to Scale in Macroeconomics

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